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The Failure of Good Intentions: The WorldCom Fraud and the Collapse of American Telecommunications After Deregulation

J. Gregory Sidak

Abstract

This paper was substantially revised in March 2003 to analyze WorldCom’s fraud and bankruptcy and the FCC’s February 20, 2003 decision its Triennial Review of mandatory unbundling. To date, policymakers and scholars have failed to recognize how those topics are interrelated.

The United States has spent seven years trying to deregulate telecommunications. We are not in the transition any longer. It is time to take stock. In this essay, I address three topics. The first, addressed in Part I, is the administrative cost of deregulation, which has grown substantially under the Telecommunications Act of 1996.

Part II addresses the consequences of the FCC’s use of a competitor-welfare standard when formulating its policies for local competition, rather than a consumer-welfare standard. I evaluate the reported features of the FCC’s decision in its Triennial Review. Press releases and statements concerning that decision suggest that the FCC may have finally embraced a consumer-welfare approach to mandatory unbundling at TELRIC prices. The haphazard administrative process surrounding the FCC’s decision, however, increases the likelihood of reversal on appeal.

Beginning in Part III, I address at greater length the WorldCom fraud and bankruptcy. I offer an early assessment of the harm to the telecommunications industry from WorldCom’s fraud and bankruptcy. I explain how WorldCom’s misconduct caused collateral damage to other telecommunications firms, government, workers, and the capital markets. WorldCom’s false Internet traffic reports and accounting fraud encouraged overinvestment in long-distance capacity and Internet backbone capacity. Because Internet traffic data are proprietary and WorldCom dominated Internet backbone services, and because WorldCom was subject to regulatory oversight, it was reasonable for rival carriers to believe WorldCom’s misrepresentation of Internet traffic growth. Event study analysis suggests that the harm to rival carriers and telecommunications equipment manufacturers from WorldCom’s restatement of earnings was $7.8 billion. WorldCom’s false or fraudulent statements also supplied state and federal governments with incorrect information essential to the formulation of telecommunication policy. State and federal governments, courts, and regulatory commissions would thus be justified in applying extreme skepticism to future representations made by WorldCom.

Part IV explains how WorldCom’s fraud and bankruptcy may have been intended to harm competition, and in the future may do so, by inducing exit (or forfeiture of market share) by the company’s rivals. WorldCom repeatedly deceived investors, competitors, and regulators with false statements about its Internet traffic projections and financial performance. At a minimum, WorldCom’s fraudulent or false statements may have raised rivals’ costs by inducing inefficient investment in capacity or inefficient expenditures for customer acquisition and may have artificially reduced WorldCom’s cost of capital and thus facilitated its long string of acquisitions.

During the prebankruptcy period, WorldCom’s business strategy may have been designed to harm rival providers of Internet backbone or long-distance services. Because WorldCom’s real costs were unknown, its pricing of Internet backbone services bore no relation to cost. Recoupment of losses was unnecessary as a condition for plausible predation by WorldCom because its management had other ways to profit personally. The coordinated actions of WorldCom’s management, its investment bankers, and its auditors may have injured competition in the telecommunications industry.

Part V argues that the FCC has a unique obligation-distinct from the mandate of the bankruptcy court or the Securities and Exchange Commission-to investigate the effect of WorldCom’s misconduct on the telecommunications industry. For WorldCom, Chapter 11 bankruptcy can be a means to distort competition in the long-distance and Internet backbone markets. Because Chapter 11 bankruptcy is not designed to eradicate anticompetitive business models or to establish policy for the telecommunications infrastructure, the FCC is uniquely empowered to defend the competitive process. After Chapter 11 reorganization, WorldCom’s freedom from debt would enable the firm to underprice rivals that are as, or more, efficient than WorldCom. Economic efficiency would suffer because consumers would pay less than the true social cost required to supply the services offered by WorldCom. Moreover, the competitive advantage conferred upon WorldCom by the U.S. bankruptcy court’s elimination of WorldCom’s debt (in whole or in part) could constitute state aid in violation of Article 87 of the European Community Treaty.

In Part VI, I argue that WorldCom’s exit from the market would not carry significant social costs. WorldCom’s value as a going concern is dubious, and other carriers could readily absorb WorldCom’s Internet and long-distance customers. The FCC should investigate the ramifications of WorldCom’s fraud for telecommunications policy. The outcome of that investigation may include the finding that WorldCom is unqualified to hold its FCC licenses and authorizations. That legal conclusion would promptly, and properly, propel WorldCom toward liquidation.